Lehman's CDS Mess: Who's on the Hook?

Includes: AIG, CS, DB, GS, JPM, LEHMQ, MS
by: Bo Peng

On Oct 21, somebody [group A] will have to pay somebody else [group B] billions in cash to settle Credit Default Swaps (CDS) on Lehman. Estimates on what this entails range from $100 billion to as much as $400 billion.

Group A will almost certainly include AIG, the biggest net seller of CDS, and many hedge funds, who have been using CDS selling as their cheap (HA!) financing source for the past few years. Besides single-name CDS specifically on Lehman, other credit derivatives such as CMCDS, CDS options, or Nth to Defaults, CDX indices and bespoke CDOs with Lehman in them will also settle, partially or in full.

This will be arguably the biggest cash-exchange day in human history to date. I don't care how much taxpayer money the government will use to bail them out, somebody will fail.

Group B includes two types. One has Lehman bonds. They will be made whole by the settlement although Lehman bonds changed hands at 8.625 cents on the dollar at Friday's auction. The other doesn't have Lehman bonds. They bought naked CDS on Lehman. They will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they can collect, that is.

Back to the more immediate concern, who is in Group A?

You could pore over the CreditFixings' auction info and guess. I think a lot of people did just that on Friday. They pounced on MS, GS, CS, and DB, who happen to be the biggest Physical Settlement Sellers (meaning they sold CDS on Lehman). JPM shot up the whole day, which happens to be the biggest buyer.

But I don't know how productive this guessing game is. The dealers could be placing orders and requests for their hedge fund clients. Short of serious insider info, there's no way of knowing how much of those requests are for themselves vs. clients.

More importantly, physical settlement will almost certainly be just a small portion of the overall settlement size. Friday's auction had $5.7B in sell orders. Cash settlements will most likely be at least 10, and maybe 100 times bigger than that. People learned the lesson from Delphi. Furthermore, it'd be very unusual for banks to have a huge net position in CDS, with the possible exception being their proprietary desks and funds. Again, the most likely suspects are AIG and hedge funds.

Now you know what the government bailout of AIG is for - the initial $85B and then the additional $37.8B (suspiciously precise isn't it?). Don't be surprised if the number goes up again before 10/21. Will tax-payers get the money back after 10/21? Fat chance. Is the money really for saving AIG, or making sure others who bought CDS on Lehman will get their windfall? Take your pick.

On to the hedge funds. They knew how much they would need to pay since Lehman's bankruptcy. Reportedly JPM, GS, and MS have issued massive margin calls to their hedge fund clients, which is consistent with their sell requests (except JPM who, being the clearing bank for Lehman, may have bought protection) at the ISDA auction and my suspicion is that a big part of their requests are on behalf of their clients. Some hedge funds are being forced to cash out. And since Thursday some apparently went shorting in desperation, trying to make a quick buck before the doomsday. The 900 point surge Friday at 3 p.m. in half an hour showed how nervous and desperate they are.

In the meantime, of course, hedge fund investors must be withdrawing as fast as they possibly could, adding to their misery. Bankruptcy law will be the golden profession for many years to come.

WaMu CDS settle on Nov 7. Their impact is expected to be much smaller, although nobody can be sure, as is the case with all CDS. We may get some rough idea on its auction date, 10/23. If there are high-profile bankruptcies on 10/21 (banks, AIG), then markets will be spooked and all eyes would then turn to WaMu; otherwise it'd likely be a non-event in comparison.

If there were bankruptcies of anything other than hedge funds on 10/21 (or 11/7, though less likely), then we could be in a serious chain reaction. But governments all over the world would band together to stop it. Governments may be stupid and inept, but they're not suicidal. The Fed's discount window will stay open late on 10/21. For banks (or AIG) who cannot post enough collateral, Paulson will be ready to buy stocks in a heartbeat. If the initial $250 billion runs out that day, they can let foreign sovereign funds buy preferred stocks. It's a wonderful world.

Moreover, I suspect the pending doomsday is a big reason why banks have shied away from lending to each other over the past few weeks. Nobody knows how much anybody else owes on that day. Coming 10/22, assuming no banks fail, it'd be a huge cloud gone. Back to business as usual, or as usual as it gets nowadays.

Hedge funds' fire-sale exit may be creating a very rare buying opportunity in many financial markets (stocks, bonds, commodities, maybe even dreaded CDOs and mortgages). A few days ago I wondered if the bottom was near. Now I'm convinced the bottom will be around 10/21, if not earlier. The way back up may be painfully fast or painfully slow. But the crisis is essentially over unless we let the chain reaction take place.

Then we'll only have to deal with the massive debt, recession, and inflation. Piece of cake.

Disclosure: None